How much will your tax refund be? Depends on many factors

Recently I have had two clients who were in to pick up their completed tax forms and they were surprised and frustrated with the balance due on their returns. In both cases the clients had taxable investment accounts that were managed by a financial advisor. In both cases due to the strong market growth this past year they experienced significant capital gains due to investment sales. These sales created taxable income and the corresponding income tax obligation greater than they were expecting and greater than they have recently experienced.

The amount of a taxpayer’s refund or balance due is the difference between their income tax obligation and the sum of income tax withheld, estimated tax payments made and credit carried forward from previous years.

The tax obligation is determined by adding income from all sources. Commonly this would include wages, interest, dividends, capital gains, pension income, retirement account distributions and self-employment income. For some taxpayers, adjustments are made to account for IRA contributions, health savings contributions made outside of work, student loan interest and several other categories.

This gives us the individual’s adjusted gross income from which either the standard deduction or itemized deduction is subtracted to arrive at taxable income. Once the taxable income is known the tax obligation can be calculated.

The other half of the equation is the amount of tax already paid through withholding, estimated payments or credit carried forward. The amount of tax withheld from a paycheck is determined by the information an employee entered into their form W4 when they first took the job. Your W4 may be changed at any time by contacting your employer.

For the purposes of form W4, there are 2 choices for filing status — single or married. Some forms show a third choice of married but withhold at the single rate. If both spouses work, they should each withhold at the single rate. This is because one spouse’s job will not know about the other spouse’s job and will not withhold enough to compensate for the additional income to be reported on the tax return.

The other variable on form W4 concerns the number of qualifying children under age 17 as well as any other dependents that will be claimed when taxes are filed. At the federal level, exemptions have been eliminated but most states still take into consideration the number of exemptions claimed. Estimated payment amounts are generally calculated by looking at the previous year’s tax liability and comparing the current year’s estimated income with the previous year’s reported income.

As you can see there many factors which impact a tax refund.

Only after comparing the 2021 and 2020 values for taxable income, tax liability, credits and withholding can you determine if you paid more or less tax in 2021 compared to 2020. Many taxpayers will find that their withholding was reduced through the year and that is why their refund is smaller than last year.

Using a tax refund as a form of savings plan is generally not the best strategy.

The IRS does not pay interest on overpayments, and for a taxpayer to rely on a refund with ever-changing tax laws and tax situations is not a financially solid decision. It would be more prudent to actually have a portion of the paycheck direct deposited into a savings account and withhold an amount sufficient to meet the projected actual tax obligation. Also, our situation changes from year to year. This past couple of years there have been additional tax credits and child tax credits as a result of COVID that impacted some taxpayers’ returns as well. There are numerous examples of situations occurring that a taxpayer did not foresee that impacted their tax obligation and refund. From births to aging to changing tax laws, the tax obligation and tax refund for an individual is often inconsistent.

Paul Pahoresky is a partner in the accounting firm of JLP CPAs. He can be reached at 440-970-1040 extension 14 or at paul@jlpcpas.com. Consult your tax advisor for your specific situation for additional information and guidance on these topics.